The planned launch of a new bond trading
system for US high-yield bond instruments next month offers potential evidence
of a trend towards sell-side disintermediation in the fixed income market.

But despite an increasingly tough business
environment for fixed income dealers a substantial reduction in their role is unlikely to meet the needs of the market.

Having first launched in Europe just over
two-and-a-half years ago, Vega-Chi, which was set up by former Goldman Sachs
trader Constantinos Antoniades, is planning to debut its first US venue on 24
October. The platform will have 45 buy-side clients ready to trade corporate
bonds on day one and expects to have 80 members within five months of going
live.

“Within the last two years there has been a
big shift in the structure of the fixed income market, as the commercial models
of banks come under threat and buy-side demands increase,” Antoniades told
theTRADEnews.com. “We are attempting to address this mismatch with a solution
that lets the buy-side transact with each other directly.”

Globally, the ability to the sell-side to
facilitate the buy-side’s bond trading activity by committing capital is
already diminishing due to new measures in Basel III, the latest set of
standards to ensure banks are adequately capitalised. The rules will require
brokers to hold risk-weighted capital against some instruments held on their
balance sheets.

US banks also face further restrictions through
the Volcker rule, a ban on proprietary trading proposed by former Federal
Reserve chairman that was included in the Dodd-Frank Act, which could also have
extraterritorial reach.

While banks gear up for this shift,
Antoniades believes attitudes on the buy-side are also changing, as investment
into fixed income increases and the demand for more electronic bond trading
solutions escalates.

According to data from Strategic Insight,
an Asset International company, US$5.8 billion was invested in US equities by
US mutual funds in June and July combined, compared to an investment of US$52.1 billion in US bonds in the same period.

Cutting
out the middle man

Antoniades also believes the buy-side is
waking up to the amount of money they can save by trading directly.

“Banks have made hundreds of billions on
high-yield bond transactions over the last ten years,” he said. “The buy-side
are much more aware that they can trade directly, without the use of a bank, at
a fraction of what they are used to paying and pass these savings back to their
clients.”

So where does the future of the sell-side
lie when it comes to fixed income trading? In corporate bonds, banks now hold
just 1% of overall liquidity compared to 7-8% historically (see graph).

But Antoniades believes these only target
certain portions of the market and that banks are more keen to sustain their
core role in the fixed income market for as long as possible. Goldman Sachs’ G
Sessions platform runs infrequent auctions for corporate bonds while UBS’ PIN venue
is solely focused on credit default swaps.

“My guess is that the sell-side will try to
hold on to their business and try to maintain their margins rather than
cannibalise their businesses through lower transaction fees,” he said. “Some
banks have tried to introduce automated solutions but have so far been limited
in the scope of instruments or style of trading they offer.”

On
the sidelines

But according to George O’Krepkie, CEO of
fixed income platform Bonds.com, cutting out the sell-side could pose more
challenges than it solves.

Bonds.com offers a central marketplace for
all market participants and currently counts over 200 brokers and 800 buy-side
firms among its members. Dealers are able to stream prices in the bonds they
want to trade, removing the need for them to back client trades with their own
capital.

“Cutting dealers out isn’t really the right
model in my opinion,” said O’Krepkie. “Dealers will find ways to tackle the new
market structure that is evolving for fixed income, and are more like to favour
the ability to post prices on a central utility. Fragmenting the market between
dealers and the buy-side will only exacerbate the hunt for liquidity.”

O’Krepkie stressed relationships with
dealers will be crucial for those that want to trade bonds discreetly and in
size, with platforms that allow participants to post prices offering more value
for smaller-sized and more liquid orders.

Moreover, as new platforms for fixed income
instruments continue to emerge and facilitate the trading of smaller orders,
the technology needed to navigate the market will bear similarities to
equities.

“We have seen large buy-side houses hire
equity traders to their fixed income desk in order to learn and capitalise on
trends towards the greater use of algorithms and smart order routing,” said
O’Krepkie. “The explosive growth in the exchange-traded fund market for bonds
has also brought in new types of fixed income players that trade
algorithmically.”